Integrating multinational firms into international economics. (Research Summaries).
Markusen, James R.
James R. Markusen (*)
As recently as the mid-1980s, research on multinational firms was
almost entirely separate from research on international trade. The
latter was dominated by general-equilibrium models using the twin
assumptions of perfect competition and constant returns to scale. In
this theory, there was little role for individual firms; indeed,
theorists spoke only of industries, not firms. Multinational firms
generally were approached from a case-study perspective, or at best in a
partial-equilibrium setting.
To the extent that multinationals and foreign direct investment
were treated at all in trade theory and open-economy macroeconomics,
they were viewed as part of the theory of portfolio capital flows. The
view was that capital, if unrestricted, flows from where it is abundant
to where it is scarce. The treatment of direct investment as a capital
flow was evidenced in data sources as well. There were lots of data on
direct investment stocks and flows, but little on what multinationals
actually produced, where they produced it, and where they sold it.
It took little staring at available statistics to realize that
viewing direct investment as a capital flow was largely a mistake. The
overwhelming bulk of direct investment flows both from and to the
high-income developed countries and there is a high degree of cross
penetration by firms from these countries into each other's
markets. It also appeared that the decision about whether and where to
build a foreign plant is quite separate from how and where to raise the
financing for that plant. Lastly, casual observation suggested that the
crucial factor of production involved in multinational Location
decisions was skilled labor, riot physical capital. By the late 1970s, I
began to believe that location and production decisions should be the
focus of a new microeconomic approach to direct investment while
financial decisions should remain part f the traditional theory of
capital Flows.
Much of my work over the last two decdades (1) has thus been to
develop a microeconmicm general-equilibrium theory of the multinational
firm. This theory should satisfy several conditions. First, it should be
easily incorporated into general-equilibrium trade theory. Second, it
should be consistent with important stylized facts, such as the large
volume of cross investment among the high-income countries. Third, it
should generate testable predictions and survive more formal econometric testing.
One useful starting point for theory is a conceptual framework proposed by British economist John Dunning, who suggested that there are
three conditions needed for a firm to become a multinational. First, the
firm must have a product or a production process such that the firm
enjoys some market power or cost advantage abroad (ownership advantage).
Second, the firm must have a reason to want to locate production abroad
rather than concentrate it in the home country (location advantage).
Third, the firms must have a reason to want to own a foreign subsidiary
rather than simply license to or sub-contract with a foreign firm
(internalization advantage).
I have used these ideas as conceptual guides in building a formal
theory. In my models with Horstmann and Venables (2), the ownership
advantage is modeled by the existence of firm-level as opposed to
plant-level scale economies. The general idea is that there are
knowledge-based activities such as R and D, management, marketing, and
finance that are at least partially joint inputs across separate
production facilities in that they can yield services in additional
locations without reducing services in existing locations. We assume
that activities can be fragmented geographically, so that a plant and
headquarters can be located in different countries, for example.
Finally, we assume that different activities have different factor
intensities, such as a skilled-labor-intensive headquarters or
components production and an unskilled-labor intensive production plant.
I have termed these properties jointness, fragmentation, and
skilled-labor intensity respectively.
Jointness is the key feature which gives rise to horizontal
multinationals, firms that produce roughly the same goods and services in multiple locations. For these firms, broadly defined trade costs
constitute a location advantage, encouraging branch-plant production
abroad. Fragmentation and skilled-labor-intensity are key features which
give rise to vertical multinationals, in turn geographically fragmenting
the production process by stages. For vertical firms, low trade costs
may be a location advantage. Differences in factor endowments and prices
across countries encourage geographic fragmentation, resulting in the
location of stages of production where the factors of production they
use intensively are cheap.
These elements are not difficult to incorporate into
industrial-organization models of trade. The latter models are then
enriched by allowing firms to choose their "type" in a
first-stage, selecting the location of their headquarters and the number
and location of their plants. The second stage decision may be a Cournot
output game or a standard monopolistic-competition model. Multinationals
arise endogenously, depending on country characteristics including
country sizes, factor endowments, and trade costs.
Internalization advantages are not easily added to the same models.
The issues here are the stuff of the theory of the firm and the
boundaries of the firm in particular. The reasons for firms to wish to
own foreign subsidiaries rather than to license technology, for example,
include factors such as moral hazard, asymmetric information,
in-complete and non-enforceable contracts, and so forth. It becomes
technically awkward to incorporate these factors into
general-equilibrium models, so they often are embedded in more
specialized, partial-equilibrium models.
Nevertheless, my view is that the same properties of
knowledge-based assets that give rise to jointness also give rise to the
risk of asset dissipation, moral hazard, and asymmetric information. A
blueprint that can be used easily in a foreign plant as well as a
domestic one may also be copied easily or stolen. Licensees or possibly
the firm's own employees may quickly absorb the technology and
defect to start rival firms if contracts are not enforceable. Thus the
theory is relatively unified, but internalization or choice of mode
issues (for example, owned subsidiary, licensing, exporting) often are
addressed in specialized models.
These new models yield clear and testable predictions as to how we
should expect multinational activity to relate to country
characteristics, industry characteristics, and trade and investment
costs. Consider two countries, and an industry in which firms can
decompose production into a headquarters activity and a production
activity. Horizontal firms, which roughly duplicate the activities of
home-country plants in foreign branch plants will tend to arise when
countries are similar in size and in relative endowments, and when trade
costs are moderate to high relative to investment costs (or technology
transfer costs). In particular, it is the host-country's trade and
investment costs that matter, not the home country s costs. The results
on country size and relative-endowment similarity can best be understood
by noting what happens in countries that are not similar in one of these
respects. First, if there are plant-level scale economies, then a large
difference in country size will favor single-plant nation al firms that
are headquartered and producing in the large country, and exporting to
the small country instead of incurring the high fixed costs of a foreign
plant. Second, if countries are of similar size but differ significantly
in relative endowments, then single-plant firms headquartered in the
skilled-labor abundant country will have an advantage unless trade costs
are very high. Third, when countries are similar in size and in relative
endowments, there should be two-way direct investment in which
horizontal firms penetrate each other's market via branch plants
rather than through exports.
Vertical firms separating a single plant and headquarters, on the
other hand, are encouraged by factor-endowment dissimilarities. Under
the skilled-labor-intensity assumption just discussed, large differences
subject to moderate or small trade costs should favor locating the
headquarters in the skilled-labor-abundant country and having a single
plant in the unskilled-labor-abundant country. Factorendowment
differences between countries will be reinforced if the
skilled-labor-abundant country is also the small country. In the latter
situation, the headquarters should be located in the
skilled-labor-abundant country, while the single plant should be located
in the other country both for factor-price motives and for market-size
motives (minimizing total trade costs). Vertical activity generally
should be one way, from skilled-labor-abundant (especially smaller)
countries to unskilled-labor-abundant (especially larger) countries.
As indicated above, these are clearly testable predictions and
suggest regression equations to explain world multinational activity.
There are now a number of such studies published, including Brainard (3)
and Carr, Markusen, and Maskus (4) with others forthcoming or in working
paper form. The dependent variable is generally production in country j
by affiliates of firms headquartered in country i. The right-hand-side
variables (including interaction terms among these variables) are the
country sizes, country factor endowments, trade costs in both
directions, investment barriers, and industry-specific variables such as
firm and plant scale measures, R and D indexes, and so forth. The
general approach outlined above gets good support in the empirical
analysis. Key variables have the correct signs and generally high
statistical significance. Outward multinational activity from country i
to country j (production by affiliates of country i firms in j) is
increasing in the joint market size, decreasing in size di fferences,
increasing in the relative skilled labor abundance of country i,
increasing in country j's inward trade cost, and decreasing in
country j's investment barriers. Across industries, affiliate
activity is in-creasing in measures of firm-level scale economies such
as R and D, headquarters activities, and advertising intensity, and is
decreasing in plant-level scale economies.
There seems to be some consensus that, if one were to look for a
single model that is effective in explaining a large proportion of
multinational activity, we would clearly choose a pure horizontal model
over a pure vertical model. The casual evidence discussed earlier is
confirmed by formal econometric testing: multinational activity is
highly concentrated among the high-income developed countries with
significant two-way penetration of each other's markets in similar
products. Such investments quantitatively dominate activity from
developed to developing countries. Thus a theory based on
knowledge-based assets and firm-level scale economies seems to be a much
better approach than a more obvious and traditional theory based on
factors flows.
To say that the horizontal approach is a better overall model than
a vertical theory is not, of course, to say that vertical activity is
unimportant. It is clearly important in many sectors and for many
developing host countries and no one is suggesting otherwise. Recent
empirical papers by Hanson and Slaughter (5) and Yeaple (6) are
quantifying the range of strategies taken by multinational firms across
industries and host countries. It is also worth emphasizing that some
vertical activity, including assembly, footwear, and clothing production
is carried out by independent contractors in developing countries and
thus does not appear in the affiliate production statistics.
Future work will likely proceed on several fronts. In the theory
area, more work on internalization or micro-theory-of-the-firm models
would be welcome, creating a better understanding of the choice of mode
by firms. It is particularly desirable if new models can be fitted
together with the general-equilibrium models emphasizing ownership and
location. Further work with the general-equilibrium models connecting
production decisions with factor markets is important. There seems to be
some two-way causality at work, where multinationals are only attracted
to countries with minimum levels of labor skills and social
infrastructure, yet the entry of multinationals in turn contributes to
skill upgrading and skill accumulation.
In the empirical area, work on the choice of mode is also
desirable. Why do we see owned-subsidiaries in electronics assembly, but
rarely see them in clothing and footwear production which use
independent contractors? When and why do we see licensing instead of
owned subsidiaries? More clarification on the importance of vertical
firms is also desirable, and on the use of certain countries as export
platforms.
Research on policy issues also is needed. The two-way causality
just noted is important for public policy and suggests the possibility
of multiple equilibriums and low-level development traps. While much
work has been done on taxes, there is virtually none on the importance
and composition of government expenditure. Yet casual evidence suggests
that social infrastructure, including physical, educational, and legal
infrastructure, is very important in attracting inward investment.
Markusen is a Research Associate in the NBER's Program on
International Trade and Investment. He is the Stanford Calderwood
professor of Economics at the University of Colorado, Boulder. His
profile appears later in this issue.
(1.) Most of my work on multinationals has now been rewritten,
synthesized, and extended in: J. R. Markusen, Multinational Firms and
the Theory of International Trade, Cambridge: MIT Press, forthcoming in
2002.
(2.) I. J. Horstmann and J. R. Markusen, "Endogenous Market
Structures in International Trade," NBER Working Paper No. 3283,
March 1990, and in the Journal of International Economics 32 (1992), PP.
109-129; J. R. Markusen and A. J. Venables, "Multinational Firms
and the New Trade Theory," NBER Working Paper No. 5036, February
1995, and in Journal of International Economics, 46 (1998), pp. 183-204;
J. K. Markusen and A. J. Venables, "The Theory of Endowment,
Intra-Industry and Multinational Trade," NBER Working Paper No.
5529, April 1996, and in Journal of International Economics, 52 (2000),
pp. 209-35.
(3.) S. L. Brainard, "An Empirical Assessment of the
Proximity-Concentration Tradeoff between Multinational Sales and
Trade," NBER Working Paper No. 4580, December 1993, and in American
Economic Review, 87, (4) (September 1997), pp. 520-44; S. L. Brainard,
"An Empirical Assessment of the Factor Proportions Explanation of
Multi-Nationals Sales," NBER Working Paper No. 4583, December 1993.
(4.) D. L. Carr, J. R. Markusen, and K. E. Maskus, "Estimating
the Knowledge-Capital Model of the Multinational Enterprise," NBER
Working Paper No. 6773, October 1998, and in American Economic Review,
91 (2001), pp. 693-708. J. R. Markusen and K. E. Maskus,
"Multinational Firms: Reconciling Theory and Evidence, "NBER
Working Paper No. 7163, June 1999, and in Topics in Empirical
International Economics: A Festschrift in Honor of Robert E. Lipsey, M.
Blomstrom and L. Goldberg eds., Chicago: University of Chicago Press,
2001; J. R. Markusen and K. E. Maskus, "Discriminating Among
Alternative Theories of the Multinational Enterprise," NBER Working
Paper No.7164, June 1999.
(5.) G. H. Hanson, R. J. Mataloni, Jr., and M. J. Slaughter,
"Expansion Strategies of U.S. Multinational Firms," NBER
Working Paper No. 8433, August 2001.
(6.) S. R. Yeaple, "The Role of Skill Endowments in the
Patterns of U.S. Outward Foreign Direct Investment," University of
Pennsylvania Working Paper, 2001.